China, ECB, odd bedfellows in the euro’s resilience

Commentary: Interest-rate differentials are key

MichaelCasey

NEW YORK (MarketWatch) — To volatility-loving currency traders, the euro has been a source of great frustration, its trade versus the dollar hewing to a boring range of 4 cents for almost four months.

For that they can blame an unintentional symbiosis between the European Central Bank and the People’s Bank of China, the first via its stubbornly hands-off view of markets, the latter for being hyper-interventionist.

Central-bank policies explain why buyers frequently emerged whenever the euro dipped below $1.30 in February, March and April. And they’re preventing it from collapsing more rapidly now that it has finally broken below that level and has reached its weakest point since Jan. 25.

They are why currency traders have tended to turn off the noise from the euro-zone debt crisis this year: the biggest debt restructuring in history, a continent-wide recession, a worrying downturn in Spanish bond markets, and on Sunday, a voter rebellion in France and Greece that could derail existing efforts to control the crisis.

One thing is for sure: The euro’s defiance of gravity has had little to do with the prognosis for the crisis itself. It can’t be because investors believe Europe’s leaders will eventually do what is needed to save the euro, since getting there will likely require big, currency-weakening measures, including more growth-killing austerity and a capitulation by the ECB to print massive amounts of euros. But neither should we trust the counterintuitive argument that the departure of Greece or another peripheral “weak link” from the monetary union will make the remaining sum of its parts stronger and thus bolster the euro. This ignores the threat to the euro-zone banking system that would come from a flood of Greek or Portuguese defaults.

To get to the heart of the euro’s stickiness, we must start with a concept from FX 101: the role played by interest-rate differentials.

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People's Bank of China Gov. Zhou Xiaochuan.

With its 1.0% refinancing rate, the ECB stands apart from its main counterparts--the U.S. Federal Reserve, the Bank of Japan, the Bank of England and the Swiss National Bank--whose benchmark rates range from zero to 0.5%. What is more, these central banks have all adopted aggressive supplemental measures that the ECB has resisted: “quantitative easing” bond-buying on the part of the Fed, BOE and the BOJ; a floor rate for the euro/Swiss franc exchange rate on the part of the SNB. By default, this creates what is known as “positive carry” for the euro.

This could change if the ECB were to signal a softer line in the future. But after its policy-setting meeting on Thursday, President Mario Draghi described current policy as “accommodative” and said the ECB didn’t even discuss the idea of a rate cut.

This insistence on hard money, even in the face of a euro-zone recession, stems from both the historical aversion to inflation at its most-powerful member national bank, the Deutsche Bundesbank, and the fact that Germany, bucking the European trend, enjoys near-full employment and faces inflation pressures. Yet this simply highlights a key structural problem in the euro zone: the absence of a one-size-fits-all monetary policy to suit the zone’s vast array of economic circumstances. Ultimately, this should weigh against the euro, offsetting the effect of positive carry.

This structural problem means the ECB’s monetary stance can’t singlehandedly prevent the euro from falling, which is why it depends on a helping hand--though it isn’t necessarily a welcome one--from China’s central bank and sovereign-wealth funds.

It is widely known that the PBOC is diversifying its $3.1 trillion stockpile of foreign-currency reserves out of dollar assets, a move that includes buying the euro. Yet from all accounts, China’s interest in the European currency reflects something more than a simple portfolio reallocation. Evidence suggests that Chinese state institutions are effectively intervening to manipulate the euro exchange rate, perhaps to offset the competitiveness that the country’s exporters have lost to the dollar now that the yuan has appreciated. Over the previous three months, traders referred so frequently to buy orders by a “large Asian central bank” that it became conventional wisdom that China was deliberately stopping the currency from falling below $1.30.

In reality, it plays out in a more-complicated way than that, with the mere expectation of Chinese buying encouraging self-fulfilling actions by other market participants. For example, traders cite the presence of some very big put options, which give the holder the right to sell euros at a predetermined price, carrying a strike price below $1.29. Given the potential for big payouts if that level gets broken, there is a big incentive for those who have written those options to buy the euro in the spot market and prevent it from falling.

Still, none of this would be possible without central banks creating market expectations. If either the ECB or the PBOC send a different signal, the euro will tank.

Michael Casey’s new book on the global financial system, “The Unfair Trade,” will be published on May 29.

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